EconoBytes-Thursday, January 16, 2014 | Roosevelt Institute

ECONOBYTES-THURSDAY, JANUARY 16, 2014

Today, Inequality and the Great Recession

Thursday, January 16, 2014

In the next two editions of EconoBytes, Steven Fazzari, Professor of Economics and Associate Director of the Weidenbaum Center on the Economy, Government, and Public Policy at Washington University in St. Louis, discusses the ways in which rising income inequality since 1980 set the stage for the Great Recession and is holding back the recovery.

His analysis, with accompanying charts, focuses on factors that are often overlooked in the current policy debates:

The potentially devastating consequences for growth and job creation of wage stagnation for the bottom 95% of the income distribution were largely ignored prior to the crash as their effect on consumption and economic growth were masked because households compensated for slow wage growth by depleting their savings and by borrowing heavily, particularly against the steadily inflating value of their homes.

The bursting of the housing bubble, accompanied by the financial meltdown, kicked the props out from under consumption by the 95%.

The way the economy generated the demand it needed to grow jobs in the period before 2007 was unsustainable. Even if we fix finance, we will still need to increase wages for the bottom 95% to ensure adequate and sustainable economic growth in the future.

With little change in the conditions and policies that have led to wage stagnation and rising income inequality, optimistic forecasts about economic growth in 2014 (and beyond) should be viewed skeptically.

During the “Consumer Age” period from the early 1980s through 2007, much of U.S. demand growth was generated by the rapid growth of consumer spending financed by unprecedented increases in household debt.

The rise in consumer spending relative to income appears to be a paradox to some. If high-income people spend a smaller share of their income than everyone else, rising inequality should reduce the overall share of income spent. How can this paradox be resolved?

Rising income inequality corresponds almost exactly with the rise in household debt relative to income.

The chart below shows the share of pre-tax income earned by the top 5% (blue solid line, left scale). This share was remarkably stable from 1960 until the early 1980s, but then began to rise sharply. The debt-income ratio for households (red dotted line, right scale) has almost the same pattern up until the Great Recession. It was stable from 1960 through 1983 and then began to increase.

This correspondence was not a coincidence: rising income inequality was a central factor that led to increased household debt and therefore to the forces that created the housing bubble and, finally, the Great Recession.

How can we resolve the paradox of strong household spending despite rising income inequality?

The inequality trend shown in the chart above resulted in large part from slowing income growth for the bottom 95%.

While households could have responded by cutting either consumption growth or saving growth, what actually happened is that saving growth fell and borrowing increased.

Lower saving rates rescued the economy from demand drag that might have come from rising inequalityduring the “Consumer Age.”

But it also put the ratio of household debt to income on an unsustainable path; the unsustainable rise in debt set the stage for the Great Recession.

Inequality, Income Growth, and the Rising Fragility of Household Balance Sheets

From 1960 to 1980, inflation-adjusted income for the bottom 95% grew at an average rate of 3.9% per year while average growth for the top 5% was 4.0%.

Between 1980 and 2007, average real income growth for the bottom 95% dropped to 2.6% per year while growth for the top 5% accelerated to 5.0%

The rising debt trend was much more severe in the bottom 95% according to data from the Federal Reserve’s Survey of Consumer Finance. The debt-income ratio rose 71 percentage points for the bottom 95% between 1989 and 2007, but just 6 percentage points for the top 5% (see the chart below).

Eventually this behavior of the bottom 95% collided with limits on further borrowing when interest rates rose and the bubble in housing prices burst.

With liquid savings depleted and much new borrowing cut off, spending for personal consumption and new homes collapsed and the Great Recession began.

The beginning of this “deleveraging effect” for the bottom 95% is evident in the chart below.

Special thanks to Steven Fazzari and Washington University for today’s EconoBytes. For a more detailed presentation of these ideas targeted to a general audience, please go to Professor Fazzari’s “Muddy Water Macro” web site pages on the Great Recession.

EconoBytes: What Progressive Economists and Policy Experts are Saying TodayEconoBytes is a quick daily economic roundup for journalists, sponsored by the Roosevelt Institute and compiled by Fenton Communications. We bring together blogs, analyses, and studies by progressive economists, policy experts, and think tanks on the most pressing issues in the current public economic debate.